A popup window will show up asking you if you would you like to prepare the virtual hard disk(s) for compaction, select yes and let it finish. Note: if you don't see any popups, go to "My Computer" and double click your CD Drive.

Wait for it to finish then Shut down your virtual machine.

Open "Virtual PC Console (the one you use to manage all your virtual PCs).

Click File-> Virtual Disk Wizard.

In wizard, Click Next -> Edit an existing virtual disk -> select the VHD we just compacted and click Next -> Compact It -> Save the File As (just in case the compaction fails) and select a location for your VHD.

Click Finish and it will compact your VHD.

After process is done, make sure your settings file is pointing to the new VHD.